option question?

Question

One of the financial newsletters was bragging about the money they made in options. They told their readers to buy $180 put options for a stock trading at $218 for $12 premium. After a month, they told the readers to sell the options. At that time, option premium was $15 and the stock price was $182. They are saying that they made 25% profit ((15-12)/12). However, to me, the option is worthless since it is out of money. The option does not have a value until stock price hits at least $182. Even then, you will be still at loss since you had yo pay for the premium. The price has to go down to $170 for you to break even on this investment. Am I missing something?

Answer 1

I think the problem is that you are only looking at the value of the option at expiration, when all of its value comes from intrinsic value and there is no time premium.

Prior to expiration there is almost always some "time premium" included in an option's trading price. As long as there are people willing to pay that "time premium" the option is worth more than its intrinsic value.

An option is worth what someone else is willing to pay for it, so as long as someone is willing to pay $15.00 for it the option cannot be called worthless even if it has no intrinsic value.

Answer 2

Yes. You are missing something.

If you followed their advice, you made a $3 profit on a $12 investment. A grade schooler could tell you that this is a 25% return on investment.

The value of an option includes more than the intrinsic value (amount it is in the money). It is the present value of the expected value of the payoff.

Answer 3

You don't have to exercise options for them to be worth something. As long as it's not expired, they could sell it for the $15 premium. Hence, the 25% gain.

Answer 4

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